Economics Lecture Notes – Chapter 5

PRODUCTION AND COSTS will be taught in economics tuition in the eighth and ninth weeks of term 1.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1 INTRODUCTION

Production is the process by which factor inputs are transformed into output. An increase in the quantity of factor inputs will lead to an increase in output. The theory of production is the study of how the output level changes as the quantity of factor inputs changes. To increase output, firms need to employ more factor inputs which will lead to an increase in costs. The theory of cost is the study of how the cost of production changes as the output level changes. When a firm expands its scale of production, its average cost will usually fall and this phenomenon is called internal economies of scale, or simply known as economies of scale. However, when the scale of production of a firm reaches a certain size, a further expansion may lead to a rise in its average cost and this phenomenon is called internal diseconomies of scale, or simply known as diseconomies of scale. A firm may experience a fall or rise in its average cost when the industry expands, even though its scale of production remains unchanged, and these phenomena are called external economies of scale and external diseconomies of scale respectively. This chapter provides an exposition of the theory of production and the theory of cost.

2 THE SHORT-RUN THEORY OF PRODUCTION

2.1 Marginal Returns

If a firm wants to increase output, it can almost immediately employ more labour. However, it will not be able to employ more capital in the same time frame as acquisition of capital takes time. In economics, we distinguish between two types of factor inputs: variable factor input and fixed factor input. Variable factor inputs are factor inputs whose quantities can be changed in the short run. An example is labour. Fixed factor inputs are factor inputs whose quantities are fixed in the short run. An example is capital.

The short run is the time period during which at least one of the factor inputs used in the production process is fixed. It does not correspond to any specific number of weeks, months or years as it varies from firm to firm and from industry to industry. For example, a web hosting firm may take only a few weeks or even days to increase its production capacity by purchasing more servers. However, an oil refining firm may take many years to increase its production capacity due to the long time period needed to build oil refineries.

Suppose that a firm employs two factor inputs: capital and labour. In this case, the fixed factor input is capital and the variable factor input is labour. As the quantity of capital is fixed in the short run, the firm can increase output only by employing more labour.

Example

Capital

Labour

Total Output

Additional Output

5

0

0

—

5

1

3

3

5

2

7

4

5

3

12

5

5

4

18

6

5

5

22

4

5

6

24

2

5

7

24

0

5

8

23

-1

5

9

20

-3

In the above table, from the first unit of labour to the fourth, each additional unit of labour is adding more to total output than the previous additional unit and hence the firm is experiencing increasing marginal returns. Increasing marginal returns occur when each additional unit of a variable factor input (e.g. labour) is adding more to total output than the previous additional unit. This occurs due to under-utilisation of the fixed factor inputs (e.g. capital). However, from the fifth unit of labour onwards, each additional unit of labour is adding less to total output than the previous additional unit and hence the firm is experiencing diminishing marginal returns. Diminishing marginal returns occur when each additional unit of a variable factor input (e.g. labour) is adding less to total output than the previous additional unit. This occurs due to over-utilisation of the fixed factor inputs (e.g. capital). Diminishing marginal returns set in when the fifth unit of labour is employed. Furthermore, the seventh unit of labour is actually redundant. Total output even falls when the eighth unit of labour is employed.

The law of diminishing marginal returns states that if an increasing quantity of a variable factor input is used with a constant quantity of fixed factor inputs, an output level point will be reached beyond which each additional unit of the variable factor input will add less to total output than the previous additional unit. To put it somewhat differently, the law of diminishing marginal returns states if a firm increases output continually in the short run, it is a matter of time that diminishing marginal returns will set in. If the firm starts with a small quantity of fixed factor inputs, diminishing marginal returns will set in earlier. If the firm starts with a large quantity of fixed factor inputs, diminishing marginal returns will set in later.

2.2 Total Product, Marginal product and Average product (Optional but good to know)

Total Product

Total product (TP) is the total output produced with a given amount of factor inputs.

The total product curve is S-shaped.

Total Product Curve

In the above diagram, the TP curve shows how total output varies with the quantity of labour, given the quantity of capital. From the first unit of labour to QL0, the firm is experiencing increasing marginal returns and hence total output is rising at an increasing rate when the quantity of labour increases. After QL0, the firm is experiencing diminishing marginal returns and hence total output is rising at a decreasing rate when the quantity of labour increases. After QL2, the problem of diminishing marginal returns becomes so severe that additional units of labour actually lead to a fall in total output.

Marginal Product

Marginal product (MP) is the additional output resulting from employing one more unit of labour.

Marginal product is calculated by dividing the change in total output by the change in the quantity of labour.

ΔTP

MP = ——–

ΔQL

The marginal product curve is inverted-U-shaped.

Marginal Product Curve

In the above diagram, from the first unit of labour to QL0, the firm is experiencing increasing marginal returns and hence MP is rising. After QL0, the firm is experiencing diminishing marginal returns and hence MP is falling. After QL2, the problem of diminishing marginal returns becomes so severe that additional units of labour actually lead to negative MP.

Average Product

Average product (AP) is the output per unit of labour.

Average product is calculated by dividing total output by the quantity of labour.

TP

AP = ——–

QL

The average product curve is inverted-U-shaped.

To understand the shape of the average product curve, we need to understand the relationship between average value and marginal value which can be illustrated with the following example.

Assume that the average height of a particular class of students is 1.7 metres. Further assume that a new student joins the class. If the height of the new student, which is the marginal height, is higher than the average height of 1.7 metres, the average height of the class will rise. However, if the height of the new student is lower than the average height, the average height of the class will fall. Therefore, when the marginal value is higher than the average value, the average will rise and vice versa. This applies to the relationship between average product and marginal product.

Average Product Curve

In the above diagram, from the first unit of labour to QL1, MP is higher than AP and hence AP is rising. After QL1, MP is lower than AP and hence AP is falling. The above analysis does not only explain why the AP curve is inverted-U-shaped, it also explains why the MP curve cuts the AP curve at the maximum point.

Note: Students are not required to draw the product curves in the examination as they have been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. Nevertheless, it is good for them to have a basic understanding of the product curves in order to have a better understanding of the cost curves.

3 THE LONG-RUN THEORY OF PRODUCTION

3.1 The Least-cost Combination of Factor Inputs (Optional but good to know)

The long run is the time period after which all the factor inputs used in the production process are variable. In the long run, if a firm wants to increase output, not only can it employ more labour, it can also employ more capital whose quantity is fixed in the short run. Like the short run, the long run does not correspond to a specific number of weeks, months or years as it varies from firm to firm and from industry to industry.

The least-cost combination of factor inputs is used when the last dollar of each factor input employed produces the same additional output. If a firm employs two factor inputs, labour (L) and capital (K), the least-cost condition can be expressed as MPL/PL = MPK/PK, where MP denotes marginal product and P denotes price.

Suppose that MPL/PL is twice MPK/PK. In other words, the additional output produced by the last dollar of labour employed is twice the additional output produced by the last dollar of capital employed. In this case, the firm can reduce the total cost of producing the same amount of output by employing more labour and less capital. For example, if the firm employs one more dollar of labour and two dollars less of capital, although total cost will fall by one dollar, total output will remain constant which will lead to a fall in the total cost of producing the same amount of output. However, as the quantity of labour increases, MPL will fall due to diminishing marginal returns. Similarly, as less capital is employed, MPK will increase. This process will continue until MPL/PL = MPK/PK. In other words, the additional output resulting from employing the last dollar of labour is equal to the additional output resulting from employing the last dollar of capital.

Note: Students are not required to explain the least-cost combination of factor inputs in the examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. Nevertheless, it is good for them to have a basic understanding of the least-cost combination of factor inputs in order to have a better understanding of ‘The Long-run Theory of Production’.

3.2 Returns to Scale

When the quantities of all the factor inputs used in the production process are increased by the same proportion in the long run, the scale of production expands. An increase in the scale of production will lead to one of three scenarios: increasing returns to scale, constant returns to scale or decreasing returns to scale.

Increasing Returns to Scale

Increasing returns to scale occur when the same percentage/proportionate increase in the quantities of all the factor inputs used in the production process leads to a larger percentage/proportionate increase in total output.

Constant Returns to Scale

Constant returns to scale occur when the same percentage/proportionate increase in the quantities of all the factor inputs used in the production process leads to the same percentage/proportionate increase in total output.

Decreasing Returns to Scale

Decreasing returns to scale occur when the same percentage/proportionate increase in the quantities of all the factor inputs used in the production process leads to a smaller percentage/proportionate increase in total output.

Example

Capital

Labour

Percentage increase in the quantities of all factor inputs

Total output

Percentage increase in total output

Returns to scale

20

4

—

100

—

—

40

8

100

250

150

IRS

60

12

50

420

68

IRS

80

16

33.33

560

33.33

CRS

100

20

25

672

20

DRS

120

24

20

780

16

DRS

From the output level 100 to the output level 420, the firm is experiencing increasing returns to scale (IRS). Increasing returns to scale occur due to division of labour and the use of larger machines. Division of labour is the process whereby each job is broken up into its component tasks and each worker is assigned one or a few component tasks of the job. An expansion of the scale of production may enable the firm to engage in greater division of labour and hence greater specialisation which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore, larger machines are often more efficient than smaller machines as they generally make more efficient use of materials and labour. Therefore, an expansion of the scale of production may enable the firm to use larger machines that are often more efficient than smaller machines which will also lead to higher labour productivity resulting in increasing returns to scale. From the output level 420 to the output level 560, the firm is experiencing constant returns to scale (CRS). From the output level 560 to the output level 780, the firm is experiencing decreasing returns to scale (DRS). Decreasing returns to scale occur due to division of labour. When division of labour increases to a high degree, workers may become demotivated as performing the same task all the time may lead to boredom. This is especially true if the task is mundane. If this happens, labour productivity will fall which will lead to decreasing returns to scale.

Note: Returns to scale will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

4 THE SHORT-RUN THEORY OF COST

4.1 Fixed Costs, Variable Costs, Explicit Costs and Implicit Costs

Fixed costs are costs that do not vary with the output level. Examples of fixed costs include rent and interest payments on loans. An increase in the output level will not lead to an increase in fixed costs. Fixed costs will be incurred even if the firm shuts down production. Variable costs are costs that vary directly with the output level. Examples of variable costs include the cost of labour and the costs of materials. An increase in the output level will lead to an increase in variable costs as more variable factor inputs are needed to produce more output. Variable costs will not be incurred if the firm shuts down production.

Explicit costs are costs that involve monetary payments. Examples of explicit costs include the cost of labour and the costs of materials. Implicit costs are costs that do not involve monetary payments. Examples of implicit costs include the cost of the owner’s labour and the cost of the owner’s financial capital. Profit is the excess of total revenue over total cost. Accounting profit is the excess of total revenue over accounting costs. Accounting costs are costs computed by accountants which include only explicit costs. Economic profit is the excess of total revenue over economic costs. Economic costs are costs computed by economists which include both explicit costs and implicit costs. As economic costs are higher than accounting costs, economic profit, which is the profit that economists are concerned with, is lower than accounting profit.

Note: Fixed costs and variable costs will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

4.2 Total Cost, Marginal Cost, Average Cost, Average Variable Cost and Average Fixed Cost

Total Cost

Total cost (TC) is the cost of the factor inputs required for the production of an amount of output.

In the short run, total cost is the sum of total fixed cost (TFC) and total variable cost (TVC) and is positively related to the output level. The total cost curve is inverse-S-shaped.

Total Cost Curve

In the above diagram, as fixed costs do not vary with the output level, the TFC curve is horizontal. However, as more variable factor inputs are needed to produce more output, the TVC curve is upward-sloping. As TC is the sum of TFC and TVC, the TC curve is geometrically similar to the TVC curve, except that the former is higher than the latter by TFC at each output level. From the first unit of output to Q0, the firm is experiencing increasing marginal returns. Recall that this means each additional unit of the variable factor input is adding more to total output than the previous additional unit. Therefore, each additional unit of output requires fewer units of the variable factor input to produce and this makes the TC curve and the TVC curve rise at a decreasing rate. After Q0, the firm is experiencing diminishing marginal returns. Recall that this means each additional unit of the variable factor is adding less to total output than the previous additional unit. Therefore, each additional unit of output requires more units of the variable factor input to produce and this causes the TC curve and the TVC curve to rise at an increasing rate.

Marginal Cost

Marginal cost (MC) is the additional cost resulting from producing one more unit of output.

Marginal cost is calculated by dividing the change in total cost by the change in total output.

ΔTC

MC = ——–

ΔQ

The marginal cost curve is U-shaped or Nike-shaped which some like to call it.

Marginal Cost Curve

In the above diagram, from the first unit of output to Q0, the firm is experiencing increasing marginal returns and hence MC is falling. After Q0, the firm is experiencing diminishing marginal returns and hence MC is rising.

Average Cost

Average cost (AC) is the cost per unit of output.

Average cost is calculated by dividing total cost by total output.

TC

AC = ——–

Q

The average cost curve is U-shaped.

Recall from Section 2.2 that to understand the shape of the average cost curve, we need to understand the relationship between average value and marginal value which can be illustrated with the following example.

Assume that the average height of a particular class of students is 1.7 metres. Further assume that a new student joins the class. If the height of the new student, which is the marginal height, is higher than the average height of 1.7 metres, the average height of the class will rise. However, if the height of the new student is lower than the average height, the average height of the class will fall. Therefore, when the marginal value is higher than the average value, the average will rise and vice versa. This applies to the relationship between average cost and marginal cost.

Average Cost Curve

In the above diagram, from the first unit of output to Q2, MC is lower than AC and hence AC is falling. After Q2, MC is higher than AC and hence AC is rising. The above analysis does not only explain why the AC curve is U-shaped, it also explains why the MC curve cuts the AC curve at the minimum point.

Average Variable Cost

Average variable cost (AVC) is the variable cost per unit of output.

Average variable cost is calculated by dividing total variable cost by total output.

TVC

AVC = ——–

Q

The average variable cost curve is U-shaped.

The relationship between average value and marginal value applies to average variable cost and marginal cost.

Average Variable Cost Curve

In the above diagram, from the first unit of output to Q1, MC is lower than AVC and hence AVC is falling. After Q1, MC is higher than AVC and hence AVC is rising. The above analysis does not only explain why the AVC curve is U-shaped, it also explains why the MC curve cuts the AVC curve at the minimum point.

Average Fixed Cost

Average fixed cost (AFC) is the fixed cost per unit of output.

Average fixed cost is calculated by dividing total fixed cost by total output.

TFC

AFC = ——–

Q

The average fixed cost curve is a rectangular hyperbola.

Average Fixed Cost Curve

In the above diagram, as TFC is constant, AFC falls when the output level increases.

The following diagram shows the relationships between the marginal cost curve, the average cost curve, the average variable cost curve and the average fixed cost curve.

In the above diagram, from the first unit of output to Q0, MC is falling due to increasing marginal returns, and is rising thereafter due to diminishing marginal returns. From the first unit of output to Q1, MC is lower than AC and AVC and hence AC and AVC are falling. After Q1, MC is higher than AVC and hence AVC is rising. After Q2, MC is higher than AC and hence AC is rising. As AC is the sum of AVC and AFC, the vertical distance between the AC curve and the AVC curve is equal to AFC. As AFC falls when the output level increases, the vertical distance between the AC curve and the AVC curve narrows as the output level increases.

5 THE LONG-RUN THEORY OF COST

5.1 Long-run Average Cost

The long-run average cost (LRAC) curve shows the lowest average cost of production at each output level when all the factor inputs used in the production process are variable in the long run. Each point on the LRAC curve is a point of tangency to the AC curve with the lowest average cost of producing the corresponding output level.

As fixed factor inputs in the short run become variable in the long run, a firm can choose the quantity of fixed factor inputs that achieves the lowest average cost of producing any output level. Suppose that a firm can choose among three quantities of fixed factor inputs: small quantity, medium quantity and large quantity. For simplicity, one can think of a small quantity of fixed factor inputs as a small factory, a medium quantity as a medium factory and a large quantity as a large factory.

In the above diagram, the average cost (AC) curves that correspond to the three quantities of fixed factor inputs are AC0, AC1 and AC2, where AC0 corresponds to the small quantity, AC1 corresponds the medium quantity and AC2 corresponds to the large quantity. As a larger scale of production enables the firm to produce a larger amount of output, AC1 is on the right of AC0 and AC2 is on the right of AC1. Furthermore, AC1 is lower than AC0 as the expansion of the scale of production from the small quantity of fixed factors to the medium quantity enables the firm to reap more economies of scale. However, AC2 is higher than AC1 as the expansion of the scale of production from the medium quantity of fixed factors to the large quantity causes the firm to experience diseconomies of scale. Economies of scale and diseconomies of scale will be explained in greater detail in Section 5.2. If the firm wants to produce an output level below Q’, the lowest-average-cost quantity of fixed factor inputs will be the small quantity that corresponds to AC0. If the firm wants to produce an output level between Q’ and Q”, the lowest-average-cost quantity of fixed factor inputs will be the medium quantity that corresponds to AC1. If the firm wants to produce an output level above Q”, the lowest-average-cost quantity of fixed factor inputs will be the large quantity that corresponds to AC2. Therefore, the LRAC curve is the bold curve in the diagram.

The above analysis is based on the assumption that the firm can choose among only three quantities of fixed factor inputs: small quantity, medium quantity and large quantity. However, if we assume that fixed factor inputs are continuously divisible and hence the firm can choose among an infinite number of quantities of fixed factor inputs, we will get a U-shaped LRAC curve. For simplicity, one can think of the ability to choose among an infinite number of quantities of fixed factor inputs as the ability to choose a factory of any size.

U-shaped LRAC Curve

In the above diagram, the assumption that fixed factor inputs are continuously divisible leads to a U-shaped LRAC curve. The falling portion of the U-shaped LRAC curve is due to economies of scale and the rising portion is due to diseconomies of scale. Although the LRAC curve is U-shaped in theory, some empirical studies have shown that the LRAC curve has a relatively large flat portion. In other words, these empirical studies have shown that the LRAC curve is saucer-shaped. This may be due to limited forces inducing economies of scale and limited forces inducing diseconomies of scale existing simultaneously and offsetting each other which leads to constant long-run average cost.

Saucer-shaped LRAC Curve

In the above diagram, the LRAC curve is saucer-shaped, which has been shown by some empirical studies. The falling portion of the saucer-shaped LRAC curve is due to economies of scale, the flat portion is due to constant long-run average cost, and the rising portion is due to diseconomies of scale.

Note: Students are allowed to use either the U-shaped LRAC curve or the saucer-shaped LRAC curve in the examination.

5.2 Internal Economies of Scale and Internal Diseconomies of Scale

Internal Economies of Scale

When a firm expands its scale of production, its average cost will usually fall. Internal economies of scale (IEOS), or simply known as economies of scale (EOS), refer to the decrease in average cost when the scale of production expands. Economies of scale are shown by a downward movement along the long-run average cost curve. Unless otherwise stated, economies of scale refer to internal economies of scale which are different from external economies of scale which will be explained in greater detail later. There are several sources of economies of scale.

Technical Economies of Scale

Recall that division of labour is the process whereby each job is broken up into its component tasks and each worker is assigned one or a few component tasks of the job. An expansion of the scale of production may enable the firm to engage in greater division of labour and hence greater specialisation which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore, larger machines are often more efficient than smaller machines as they generally make more efficient use of materials and labour. Therefore, an expansion of the scale of production may enable the firm to use larger machines that are often more efficient than smaller machines which will also lead to higher labour productivity resulting in increasing returns to scale. Recall that increasing returns to scale occur when the same percentage/proportionate increase in the quantities of all the factor inputs used in the production process leads to a larger percentage/proportionate increase in total output. When this happens, the percentage/proportionate increase in total output will be greater than the percentage/proportionate increase in total cost resulting in a fall in average cost.

Managerial Economies of Scale

Larger firms may be able to afford to create more specialised departments where specialists perform specific administrative functions. These specific administrative functions include human resource, purchasing, finance and marketing. Greater specialisation in these areas of expertise will lead to greater efficiency resulting in a fall in average cost.

Organisational Economies of Scale

Larger firms are able to spread overheads such as marketing cost and training cost over a larger amount of output. Spreading overheads will lead to lower overheads per unit of output resulting in a fall in average cost. For example, as the cost of an advertisement is independent of the amount of output produced, larger firms that produce a larger amount of output have a lower marketing cost per unit of output.

Purchasing Economies of Scale

Larger firms produce a larger amount of output. Therefore, they require a larger amount of factor inputs. It follows that larger firms are able to obtain a higher trade discount for the larger amount of factor inputs that they purchase which will lead to a fall in their average costs.

Financial Economies of Scale

Larger firms are generally perceived to be more financially stable. Greater financial stability is commonly associated with lower default risk. Therefore, larger firms generally are able to obtain loans at lower interest rates which will lead to a fall in their average costs.

Container Principle

A container costs less per unit of output the larger the size. The cost of a container depends directly on the amount of materials used to make it and hence the surface area. However, the capacity of a container depends directly on the volume. Therefore, larger containers have a bigger volume relative to surface area and hence larger firms that use larger containers have a lower container cost per unit of output which will lead to a fall in their average costs.

Internal Diseconomies of Scale

When the scale of production of a firm reaches a certain size, a further expansion may lead to a rise in its average cost. Internal diseconomies of scale (IDOS), or simply known as diseconomies of scale (DOS), refer to the increase in average cost when the scale of production expands. Diseconomies of scale are shown by an upward movement along the long-run average cost curve. Unless otherwise stated, diseconomies of scale refer to internal diseconomies of scale which are different from external diseconomies of scale which will be explained in greater detail later. There are several sources of diseconomies of scale.

Technical Diseconomies of Scale

When division of labour increases to a high degree, workers may become demotivated as performing the same task all the time may lead to boredom. This is especially true if the task is mundane. If this happens, labour productivity will fall which will lead to decreasing returns to scale. Recall that decreasing returns to scale occur when the same percentage/proportionate increase in the quantities of all the factor inputs used in the production process leads to a smaller percentage/proportionate increase in total output. When this happens, the percentage/proportionate increase in total output will be smaller than the percentage/proportionate increase in total cost resulting in a rise in average cost.

Managerial Diseconomies of Scale

When more specialised departments are created, coordination of the departments in the firm may become difficult. This is especially true if a system of coordination is not put in place. If this happens, efficiency in the various departments will fall which will lead to a rise in average cost.

Note: Internal economies and diseconomies of scale will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

5.3 External Economies of Scale and External Diseconomies of Scale

External Economies of Scale

A firm may experience a fall in its average cost when the industry expands, even though its scale of production remains unchanged. External economies of scale (EOS) refer to the decrease in average cost when the industry rather than the scale of production expands. External economies of scale are shown by a downward shift in the long-run average cost curve. There are several sources of external economies of scale.

When the industry expands, the demand for factor inputs will increase which will allow firms that supply factor inputs to the industry to expand their scales of production. When this happens, they may reap more economies of scale and hence charge lower prices to firms in the output industry. If this happens, as firms in the output industry will pay lower prices for the factor inputs that they purchase, their average costs will fall.

When an industry is small, training schools may find it unprofitable to design and conduct training courses to cater for the industry. However, when the industry expands, these training courses may become profitable to design and conduct. If this happens, firms in the industry will experience a fall in their training costs which will lead to a fall in their average costs.

An expansion of the industry may induce the government to improve the infrastructure such as the transportation network to support the industry. If this happens, firms in the industry will experience a fall in their transportation costs which will lead to a fall in their average costs.

When the industry expands, specialist firms which supply components to the industry may be set up. If this happens, as these specialist firms use dedicated machinery to produce the components, the costs of production will be lower which will lead to lower prices. As a result, firms in the industry will experience a fall in their average costs.

An expansion of the industry may lead to an increase in the number of researchers from both academia and industry who will devote their researches to the industry. If this happens, the researches conducted by these researchers will be published in research journals and be made accessible to interested parties for a fee. If the researches lead to better production technologies in the industry, average cost will fall.

External Diseconomies of Scale

A firm may experience a rise in its average cost when the industry expands, even though its scale of production remains unchanged. External diseconomies of scale (DOS) refer to the increase in average cost when the industry rather than the scale of production expands. External diseconomies of scale are shown by an upward shift in the long-run average cost curve. There are several sources of external diseconomies of scale.

When the industry expands, the demand for factor inputs will increase which will lead to a rise in the prices. When this happens, as firms in the industry will pay higher prices for factor inputs, their average costs will rise.

An expansion of the industry may exert a strain on the infrastructure such as the transportation network which will lead to congestion. If this happens, firms in the industry will experience a rise in their transportation costs which will lead to a rise in their average costs.

5.4 Economies of Scope

When the types of goods produced increase, average cost will usually fall. Economies of scope refer to the decrease in average cost due to an increase in the size of the firm associated with an increase in the types of goods produced rather than an increase in the scale of producing any one good. Economies of scope occur due to several reasons. For example, an increase in the types of goods produced will lead to a fall in the research and development cost per unit of output if the technologies that are used to produce the goods are related. An increase in the types of goods produced will also lead to a fall in the marketing cost per unit of output if the goods use the same branding.

5.5 Minimum Efficient Scale

The minimum efficient scale (MES) is the lowest output level at which economies of scale are fully reaped. With a saucer-shaped LRAC curve, the minimum efficient scale is the output level at which the long-run average cost curve (LRAC) stops falling. With a U-shaped LRAC curve, the minimum efficient scale is the output level which corresponds to the lowest point on the LRAC curve.

In the above diagram, with a saucer-shaped LRAC curve, the minimum efficient scale is Q0.

In the above diagram, with a U-shaped LRAC curve, the minimum efficient scale is Q0.

The size of a firm is often measured by its long-run output level which depends to a large extent on the minimum efficient scale. If the minimum efficient scale is low, the firm will tend to be small. Conversely, if the minimum efficient scale is high, the firm will tend to be large. However, the long-run output level of a firm does not depend entirely on its minimum efficient scale. A firm with a higher minimum efficient scale in a smaller market may have a long-run output level lower than that of a firm with a lower minimum efficient scale in a larger market. In other words, the long-run output level of a firm also depends on the size of the market in which the firm operates.

In a market with a low demand, a monopoly may emerge naturally if it can reap very substantial economies of scale due to very high capital costs. The very substantial economies of scale, coupled with a low market demand, lead to a high minimum efficient scale relative to the market demand resulting in the long-run average cost curve falling over the entire range of market demand. In such a market, a single firm can meet the market demand at an average cost which allows it to make supernormal profit. However, with two or more firms, all firms will make subnormal profit as there is simply no price that will allow any firm to cover its average cost. A monopoly that emerges in this way is known as a natural monopoly. An example of a firm with the characteristics of a natural monopoly is an electricity utility firm. Monopoly will be explained in greater detail in Chapter 6.

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